What do these four TV shows have in common: The Wonder Years, The Fresh Prince of Bel-Air, Friends, and The O.C.? There are actually two acceptable answers to this question. The first is that they all have iconic theme songs—you are guaranteed to be humming one of these for the rest of the day. But more relevantly, they all have at least one character that was played by two actors during the series—sometimes producers have to make a change and assume that no one will notice the switch.

Similarly, investors can also be forced to make a switch. Tax loss harvesting is the practice of selling a security at a loss and replacing it with one that achieves the same investment objective. The switch allows investors to create a loss for tax purposes while maintaining the target investment allocation for their portfolio. If most of your investments are in tax deferred accounts like an IRA or 401(k), there is little need for this strategy, but for all other accounts it is essential to achieve tax-efficient investing and portfolio rebalancing.

For example, say you purchase $10,000 of an S&P 500 ETF, such as Vanguard’s VOO, and the fund decreases in value by 20% over the next several months. Instead of waiting for the fund to rebound, you could sell it, recognize the $2,000 loss for tax purposes, and replace it with a total market ETF, such as Vanguard’s VTI. This new position will maintain representation of US equities within your portfolio while also allowing you to receive the tax benefits of a capital loss.

Generally, you can deduct up to $3,000 in capital losses on your tax return. So the $2,000 from the previous example could go against other capital gains, or if there are none, the entire amount can be taken against other types of income, lowering your tax bill in the process. So when you are rebalancing your portfolio, this practice is especially important. If you are forced to sell a position for a gain, tax loss harvesting from a different position would provide an offsetting loss, potentially eliminating the entire taxable gain.

Now, you may be wondering why you cannot just sell your position at a loss and repurchase it the next day. The answer is simple—there are explicit “wash sale” rules that disallow losses from securities purchased within a 30 day period before or after the sale which are “substantially identical.” So it is important that you replace the stock or fund sold with a different security but one that also achieves the same investment objectives.

Tax loss harvesting can be a fairly sophisticated procedure, so I would not recommend trying it on your own. But I do think that it is important for you to have a basic understanding of what the term means so that you can knowledgeably discuss this practice with your financial planner or investment manager.

Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.

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